Category Archives: Profit sharing

Today in ERISA History

July 16, 2001 – The IRS issues Final Regulations on Nondiscrimination Requirements for Certain Defined Contribution Plans, T.D. 8954, containing Treas. Reg. 1.401(a)(4)-8(b), also known as the Final Cross-Testing Regulations or Final Regulations for New Comparability Plans. The preamble to the regulations explain the various ways that new Treas. Reg. 1.401(a)(4)-8(b) permit a qualified plan to satisfy certain nondiscrimination requirements based on plan benefits rather than plan contributions. The regulations are effective June 29, 2001 and are applicable for plan years beginning on or after Jan. 1, 2002. The principal authors are John T. Ricotta and Linda S.F. Marshall of the IRS’ Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities).

Also on this date, the IRS releases Revenue Ruling 2001-30 describing certain conditions that a defined contribution allocation must meet to be treated as a defined benefit replacement allocation under new Treas. Reg. 1.401(a)(4)-8(b). It is authored by Kenneth R. Conn of IRS Employee Plans, Tax Exempt and Government Entities Division and John T. Ricotta and Linda S.F. Marshall of the IRS Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities).

Fail-Safe Provisions in Plan Document not Always a Good Idea

While I like a good fail-safe provision as much as the next ERISA geek, it is not always the most cost-efficient way to correct a nondiscrimination or coverage failure. The attorney who taught me how to write plan documents used to say – just because a plan document CAN contain a provision doesn’t mean that it always SHOULD contain that provision. When it comes to whether a cross-tested profit sharing plan should contain fail-safe language, the IRS said it best in Quality Assurance Bulletin FY-2001 No. 2, Jan. 25, 2001:

“It may be helpful to mention to the employer that by deleting the fail-safe provision, the corrective amendment procedures under Treasury Regulations section 1.401(a)(4)-11(g) can be utilized more efficiently. In other words, by deleting the provision, the employer will have the flexibility of deciding which test and optional rules to use in satisfying the nondiscrimination or coverage requirement. The use of a fail-safe provision eliminates this flexibility and may lead to the use of a method in satisfying IRC section 401(a)(4) or 410(b) that is not the most cost effective to the employer and the plan.”

This part of QAB FY-2001 No. 2 popped into my mind today as I worked on an -11(g) amendment. Treas. Reg. 1.401(a)(4)-11(g) can be a powerful tool to correct coverage or nondiscrimination failures. It permits a plan to be amended after the end of the plan year to retroactively increase accruals or allocations for employees who benefited under the plan during the plan year, or grant accruals or allocations to individuals who did not benefit during the plan year, so the plan can satisfy the minimum coverage requirements to Code section 410(b), the nondiscriminatory amount requirement of Treas. Reg. 1.401(a)(4)-1(b)(2), or the nondiscriminatory plan amendment requirement of Treas. Reg. 1.401(a)(4)-1(b)(4). An -11(g) amendment can also be used to make a benefit, right, or feature available to employees to whom it was previously not available so the plan can satisfy the nondiscriminatory current availability requirement of Treas. Reg. 1.401(a)(4)-4(b).

The language of Treas. Reg. 1.401(a)(4)-11(g) contains very specific requirements which should be reviewed before deciding whether an -11(g) amendment can be utilized to correct a failure, including a timing requirement that the amendment is adopted by the 15th day of the 10th month after the close of the plan year in order to be taken into account for the preceding plan year. Additionally, Treas. Reg. 1.401(a)(4)-11(g) requires that the employee actually benefits from the correcting contribution (see my earlier post – Making a Bad Situation Worse: An -11g Corrective Amendment Allocating to a Non-Vested Terminated Employee).

410(b) Testing and Employees Terminated With More than 500 Hours

I had a great question today about Code section 410(b) testing. For those of you that don’t do much testing, Code section 410(b) requires that the average benefit percentage for employees who are not highly compensated employees is at least 70 percent of the average benefit percentage for highly compensated employees. The test is a simple mathmatical calculation which breaks employees down into two groups – highly compensated employees and non-highly compensated employees – and then compares the number of employees in each group who are benefiting under the plan to the total number of employees in that group.

Today’s question was about a 401(k) profit sharing plan which requires an employee participating in the plan to work at least 1,000 hours of service AND be employed on the last day of the plan year in order to receive an allocation of the profit sharing contribution. The administrator wanted to know if they had to include terminated employees in the 410(b) test if the employee had not received an allocation because the employee had worked less than 1,000 hours of service and had been terminated before the last day of the plan year.

To answer this question, one more piece of information is needed – how many hours did the terminated employee work? The reason is that Treasury Regulation section 1.410(b)-6(f) draws a distinction between employees who terminate with 500 or less hours of service and employees who terminate with more than 500 hours of service. In a plan with a last day requirement or a service requirement to receive an allocation, an employee who does not receive an allocation of the employer contribution because they failed to satisfy the minimum period of service or last-day requirement can be treated as excludable for the plan year if they work 500 or less hours of service. If the employee in this situation worked more than 500 hours of service, the employee is not excludable but instead is included as not benefiting.

Treas. Reg. 1.410(b)-6(f)(3) has a really good example if you find this a little confusing. It states:

    “Example (1). An employer has 35 employees who are eligible to participate under a defined contribution plan. The plan provides that an employee will not receive an allocation of contributions for a plan year unless the employee is employed by the employer on the last day of the plan year. Only 30 employees are employed by the employer on the last day of the plan year. Two of the five employees who terminated employment before the last day of the plan year had 500 or fewer hours of service during the plan year, and the remaining three had more than 500 hours of service during the year. Of the five employees who were no longer employed on the last day of the plan year, the two with 500 hours of service or less during the plan year are treated as excludable employees for purposes of section 410(b), and the remaining three who had over 500 hours of service during the plan year are taken into account in testing the plan under section 410(b) but are treated as not benefit under the plan.”

IRS Resolves Part of the Cross-Testing Individual Classification Issue

In a Special Edition of Employee Plan News, dated August 2007 and released by the IRS on August 28, 2007, the IRS may have resolved at least some of the controversy over cross-testing plan allocations by placing individuals in their own classification group. The Special Edition states that the Retirement Plans FAQ on Pre-Approved and Individually Designed Plan Programs has been updated to include this information:

Satisfying the “reasonable classification” standards with the required use of the cautionary language in the sample adoption agreement — The FAQ states that a nonstandardized M&P plan must use the cautionary bolded language (beginning, “The specific categories of participants…”) if the plan chooses the participant group allocation method. Because doing so creates a separate allocation rate for each eligible employee, the regulation prohibiting the classification of employees by name will be disregarded.

The actual FAQ states:

7. A number of practitioners have inquired – how does the Sample Adoption Agreement Language of Section A, Participant Group Allocation work in operation?

Background: Revenue Procedure 2005-16, 2005-1 C.B. 674, allows adopting employers of non-standardized defined contribution Master & Prototype (M&P) plans to adopt an allocation formula that is designed to be cross-tested for nondiscrimination on the basis of equivalent benefits under I. T. Regs. 1.401(a)(4)-8.

The Service issued cross-tested language in LRM #94 in October 2006. The language in LRM #94 is designed to allow the adopting employer of an M&P plan to select either a participant group allocation method or an age weighted method for determining allocations under the plan. LRM #94 restricts the number of allowable allocation rates under a non-standardized M&P plan using the participant group allocation method, based on the number of NHCE’s and HCE’s in the plan. While the purpose of LRM’s is to assist sponsors of M&P plans in drafting plan language to conform to applicable law and regulations, it is generally not mandated. However, in order to effect consistent application of cross-testing for nondiscrimination purposes in M&P plans the Service has taken the position that non-standardized M&P plans must follow the language contained in LRM #94 in order to receive an opinion letter.

Answer: By selecting the participant group allocation method, the employer agrees to divide plan participants into a limited number of allocation rates, (groups). Each group will have the same allocation ratio. The number of groups will be limited as provided in the sample plan language. The determination of the allocation rates under the plan and the division of participants into groups must occur on or before the due date of the employer’s tax return, including extensions, for the year of allocation.

For this reason, the blank/fill-in of the Sample Adoption Agreement Language may be filled in with the following phrase or something similar thereto: “on or before the due date of the employer’s tax return for the year of allocation through written instructions from the employer to the plan administrator or trustee.”

8. Is the cautionary language in bold under Participant Group Allocation of the sample adoption agreement required language, and how are the reasonable classification standards under Regs.1.410(b)-4(b) of this language satisfied in operation?

The cautionary language is required language for a Nonstandardized M&P plan. However, since the Participant Group allocation method provides that each eligible employee will constitute a separate allocation group, the last sentence of Regs. 1.410(b)-4(b) will be disregarded for purposes of meeting such classification standards.

The last sentence of Treasury Reg. 1.410(b)-4(b) which is being disregarded states:

An enumeration of employees by name or other specific criteria having substantially the same effect as an enumeration by name is not considered a reasonable classification.

By disregarding this last sentence, the IRS seems to have resolved the issue on whether a plan using a cross-tested allocation formula can place individuals in their own classification group. This is a change for the IRS from a position taken earlier this year, when the IRS was challenging individual classification in cross-tested plans as not meeting the reasonable classification standard.

[tags]IRS, individual classification, cross-testing, cross-tested, allocation, 401(a)(4), LRM #94, reasonable classification, pension, retirement, ERISA[/tags]